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European Commission President Jose Manuel Barroso addresses a news conference at the EU Commission headquarters in Brussels on June 2. Barroso said he favored a tax on financial transactions or bank profits. A bank tax is being considered in the US as well as Europe, but how, or whether, it could work is being debated.

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The temptation to raise taxes on financial institutions is almost too great to resist. These institutions were largely responsible for the recent economic crisis. While the financial collapse cost millions of Americans their livelihoods, many top bank executives happily took their bonuses (in some cases paid with taxpayer money). And the arrogance and sense of entitlement that oozes from some is beyond offensive.

But besides making the rest of us feel better and perhaps providing a fiscal windfall for deficit-strapped politicians, would a tax on financial institutions benefit society? And if so, what form should it take? These are question being asked not only in the U.S. but by much of Europe as well. The answers, sadly, are not so clear cut.

Three of the nation’s top tax experts—Doug Shackelford, Dan Shaviro, and Joel Slemrod—have put their heads to together to try to sort it all out. They didn’t find the ideal tax, but they have developed a useful way to think about bank taxes. Their paper is a useful follow-up to a recent speech by Minneapolis Fed President Narayana Kocherlokota.

Their first question: What is the purpose of a bank tax? Is it to raise money (to reduce deficits, support a bailout fund, or pay for new spending or other tax cuts?) Is it to punish the institutions and their managers for past sins? Is it to prevent future financial madness? Or is it some combination of all three? Not surprisingly, different taxes achieve different results that often conflict with one another.

A second question: Who actually pays the tax? For example, a bank tax might hurt those who hold shares in the institution at the time the tax is announced (since it will drive down its stock price). But those investors may not have owned shares when the bank wandered into the derivatives market, so what does it accomplish to punish them?

Alternatively such a tax might be paid by depositors in the form of higher fees or lower interest rates. That’s not likely to convince banks to change their behavior. In some tax regimes, however, depositors might earn a bit more interest in return for providing banks an untaxed source of capital.

They also remind us that a “bank” tax should be designed as broadly as possible, and not on specific transactions (derivatives, for instance) or on specific institutions (banks, for instance). Targeting only encourages the institutions to redefine both themselves and their transactions to dodge the tax. Similarly, any tax should be tied as closely as possible to levies imposed by other countries to limit the ability of banks to locate in low-tax jurisdictions.

Finally, keep in mind that these taxes must somehow mesh with a new and complex set of financial regulations that Congress will soon pass.

With these and similar unpleasant truths in mind, the authors look at a financial transactions tax, a tax on bonuses, and two bank taxes—an excess profits tax and a financial activities tax. Here are their conclusions:

Financial Transactions Tax: A low tax rate on a very broad base—zillions of trades— has the potential to raise lots of money. But there is little evidence that increasing the cost of transactions improves markets.

Bonus Tax: A one-time tax on past bonuses would be a pretty blunt instrument, punishing both sinners and saints. A tax on future bonuses begs for avoidance.

Taxes on financial institutions: The devil here is in the details. President Obama proposed one and other countries are exploring their own versions. Taxing uninsured liabilities of big institutions could discourage risky investments. But the authors are skeptical about an Obama-like plan to use the revenue to finance a bank bailout fund and then cap the tax once the pot is full. However, they figure taxing profits and compensation that exceed some "normal" amount, as the IMF would through a Financial Activities Tax, might be even less useful. I’ll talk about these ideas in more detail in a future post.

Whether you agree with Dan, Doug, and Joel’s assessments of these specific taxes, take a look at their paper. It is a useful guidebook as you travel through some exceedingly unfamiliar and potentially dangerous territory.

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